Equity represents financial means provided by the shareholders of the business to be used to acquire assets and finance business activities. Alternatively equity is the amount of assets, which remains for shareholders, after all liabilities of the business have been paid off
Features of Equity
Features of equity are the following:
- Equity does not have maturity date, so there is no obligation to repay back to shareholders the invested amount on a certain date
- Equity represents a residual value of the assets after all liabilities are settled
Equity Value Calculation
Equity value can be retrieved from the Accounting Equation, where:
Assets = Equity + Liabilities, thus
Equity = Assets – Liabilities
Equity Parts
Equity consists of the following parts:
common stock
preferred stock
capital in excess of par value
retained earnings
Types of Stock
Based on the above, there are two types of stock:
- common stock
- preferred stock
Features of common stock are the following:
- it has voting rights
- there is no guarantee that dividends will be paid
- common stock holders have the first right to buy additional shares if they are issued. Therefore if share capital is increased, common stock holders have a right to buy those shares
Features of preferred stock are the following:
- preferred stock holders do not have any voting rights
- preferred stock implies a guarantee of dividends, i.e. fixed percentage or amount of dividends which will be paid for a year
- preferred stock holders, compared to common stock holders, have priority right to get back part of the assets in case of business liquidation
Necessary to emphasize that in case of liquidation, first all liabilities have to be repaid, and only remaining assets can be returned to shareholders. Here priority lies within the holders of preferred shares, and then holders of common shares
Capital in Excess of Par
In certain cases, when business is established and shareholders invest more money than par value of the shares, excess amount is called Capital in Excess of Par, which is a separate part of Equity
Retained Earnings
Retained Earnings represent profit, which is accumulated in the business and not yet distributed to the shareholders. Retained Earnings can be negative in case there is accumulated loss, which was not covered by investments from shareholders
Retained Earnings balance changes each year. Net Profit (not distributed to shareholders) or Net Loss from the Income Statement is transferred to the Balance Sheet – Retained Earnings caption.
This is a relation between the Income Statement and Balance Sheet
Dividends
Another concept closely related to Equity is Dividends
Dividends represent distribution of Net Profit to shareholders. In case the company declares dividends, it does not necessarily mean that they will be paid on the same date, In such case there is an obligation to pay them later
When dividends are declared the following entries made:
D Retained Earnings (i.e. decrease in retained earnings)
C Dividends Payable (i.e. liability to the shareholders to pay dividends at some time in the future)
Declaring dividends is not a liquidation or closure of the business. It is a distribution of the accumulated profit. The following entry is made when payable dividends are paid:
D Dividends Payable
C Cash
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